Factor-Based Investing (also known as “Smart Beta”) attempts to identify specific factors historically associated with stronger risk-adjusted returns, and create index weightings with inclination toward one or more of these factors. Factor-Based Investing is indexing re-architected to improve returns.
Traditional equity indexes are cap-weighted. Larger index weights are given to companies with greater market caps, regardless of company fundamentals or other factors that affect stock performance. Factor-Based portfolios, instead, have a proclivity toward one or more of a handful of factors that have been demonstrated to outperform traditional cap-weighted indexes over long periods of time.
Factor-Based Investing combines facets of both passive and active investing. Like an index, factor-based portfolios have a consistent, rules-based approach. At the same time, these portfolios offer exposure to factors employed by many active managers to generate alpha.
Individual factors can have periods of underperformance versus a cap-weighted approach even though, over the long term, the identified factors have historically outperformed. Atlas Capital Advisors’ portfolios address this issue by diversifying amongst four factors. The factors supported by extensive academic research and used by Atlas Capital Advisors are:
- Short-Term Reversal
A multi-factor portfolio can provide a steadier course for investors, easing periods of under-performance (as well as high points of out-performance) experienced with single-factor funds. For example, the value and momentum factors have demonstrated very low historical correlation. Between 1968 and 2020, only 15% of monthly returns were both negative for value and momentum factors. When correlations are sufficiently low, creation of a diversified portfolio can soften the cyclical behavior of individual factors across business cycles – offering the potential for lower volatility and more consistency of excess return above a cap-weighted strategy.
An additional benefit is the avoidance of buying one stock in one fund while selling the same stock in another fund, as tends to happen when holding multiple single-factor funds. Multi-factor portfolios reduce trading expenses and taxable gains associated with this phenomenon.